Adaptive Expectations
What is Adaptive Expectations?
Adaptive expectations is the assumption that people predict future inflation from recent past inflation, adjusting only after they are proved wrong.
Adaptive expectations makes people backward looking: their forecast for next year's inflation is built from what inflation has been, often just last year's rate or a weighted average of the last few. The consequence is that a rising inflation rate is underpredicted year after year, which is a systematic error, not a random one. That lag is what gives demand-side policy real bite in the short run: prices rise faster than the wages set under old expectations, real wages fall, and firms hire more. Once expectations catch up, wages reset, short-run aggregate supply shifts left, and output returns to potential at a higher price level. The contrast to draw on an exam is with rational expectations, which builds the forecast from today's information rather than from yesterday's outcomes.
Adaptive Expectations: a worked example
Suppose a worker expected 3 percent inflation, the actual rate came in at 5 percent, and she closes half the gap each year. The miss is 2 points, so she adds half of it and her new forecast is 4 percent. If inflation stays at 5 percent, the next miss is 1 point and the forecast rises to 4.5 percent, then to 4.75 percent the year after. Because her wage contract is signed on that forecast, each year's wage is set for an inflation rate the economy has already passed. Her real wage is squeezed until the forecast catches up.
The mistake students make with adaptive expectations
Students often hear adaptive expectations as a claim that people are foolish. The assumption is only that they forecast from past data, which works fine when inflation is stable and fails when it trends. A second error is putting expected inflation on the wrong curve. In the AP models a rise in expected inflation shifts short-run aggregate supply left and moves the short-run Phillips curve up; it is not drawn as a shift in aggregate demand.
Adaptive Expectations questions
What is the difference between adaptive and rational expectations?
Adaptive expectations look backward and rational expectations look forward, which is the essential difference. Someone with adaptive expectations updates only after inflation has surprised them, so they lag behind a trend, while someone with rational expectations already uses announced policy and other information available today. The choice decides whether a predictable stimulus can raise real output, so exam questions about policy effectiveness usually turn on it.
Why does adaptive expectations produce a downward sloping short-run Phillips curve?
The short-run curve slopes down because expected inflation is stuck at yesterday's rate while actual inflation rises, so real wages fall and firms hire, cutting unemployment. When expectations finally adjust upward, the whole short-run curve shifts up and unemployment returns to its natural rate at higher inflation. Repeating the trick yields higher and higher inflation with no lasting fall in unemployment.
Where does the adaptive expectations idea come from?
The adaptive form was standard in macroeconomics before the rational expectations revolution, used by Phillip Cagan in his study of hyperinflations and by Milton Friedman in his account of the natural rate of unemployment. Friedman argued that workers who expect the old inflation rate accept wages that turn out to be too low, which is why an inflation surprise lowers unemployment for a time. The natural rate hypothesis he and Edmund Phelps set out grew directly from that reasoning.
Formula / Example
This is the live Phillips Curve sandbox. Drag the curves, or open the full version.
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